Warren Buffett’s philosophy is investing in companies with a established record of success. In this video, we define great companies as those that deliver high owner earnings relative to the capital invested. Does it make sense to invest in these types of companies? Let’s check it out.
To keep things simple, we’ll use cash flow return on invested capital (CFROIC) as a measure of quality. But similar measures of quality apply too. Company A generates $3 of cash for every $10 of invested capital. Company B generates $1 for the same capital. Company A therefore is a better quality company than Company B.
Credit Suisse’s HOLT team published a study on whether wonderful companies remain wonderful.
They ranked companies into 4 segments by their return on capital from the highest 25% to the lowest 25%. They then measured the company performance to see if they migrated across each segment over 20 years.
Here are their conclusions:
• There is little evidence of mean reversion of company operating performance.
• Companies in the top 25% remain there over extended periods of time.
• Great businesses remain great. Only 9% of the top quartile move to the bottom quartile, 79% of the top quartile continue to remain in the top half.
• Poor businesses continue to report poor performance. 6% of these have a chance of moving from the bottom to the top quartile.
So, don’t bet on the superman CEO—bad businesses do not turnaround. Better to buy a good quality business at a fair price than a lousy business at bargain price.
Now, we learned that good performance is persistent. But how about the stock performance of these businesses?
Legg Mason published study that measured stock returns of good quality businesses. In this study, they similarly ranked businesses by quality. From 1997–2006, you would harvest a total return of 13.5% per year by investing in the top 20% of quality businesses. Investing in the bottom 20% would have given delivered a loss of 12.5% per year.
This means that if you invested $100 in the best 20%, you would end up with $354 over 10 years. Investing $100 in the bottom 20% would have given you $29. $354 versus $29, that’s the difference between good businesses and bad businesses.
To quote Morgan Stanley’s Michael Mauboussin: “Buy the best and sell the rest.”
